One of the underlying themes of the investment markets since the end of the Internet bubble has been the pursuit of alternative asset classes. Relying on the returns of one primary asset class, domestic equities, was shown to be a short-sighted one. One approach is that of “radical diversification” that looks to add new asset classes in search of a more efficient portfolio.

This pursuit of more exotic betas has been manifested in the rapid growth of the ETF marketplace. After fulfilling the style and sector needs of equities, the ETF providers have expanded into more exotic asset classes. A few years ago a commodity ETF was a pipe dream. Now they are quite commonplace. Today we have ETFs that follow even more exotic strategies like the so-called “carry trade” in currencies. However for some high-net worth investors and institutions these types of products are not exotic enough.

The Economist magazine has a piece that discusses the “quixotic appeal” of exotic assets.

“Exotic beta” represents the wilder fringes of this trend, the equivalent of an art collector buying old comics or baseball cards. Daniel Gore of Orthogonal Partners, a firm that specialises in the area, says the aim is to find managers who are inventive in fields that are not congested by existing investors and in markets that may suffer from mispricing. Uncovering that mispricing may require specialised knowledge that few investors possess, creating profitable barriers to entry.

Not all that long ago institutional investors were wary of “exotic” investment vehicles like hedge funds and private equity. Now a major manager of alternative assets is public and they are decidedly mainstream. The challenge for investors comes when every one and their brother tries to shift into these asset classes.

The trouble is that, in aggregate, investors suffer from a version of Tantalus’s curse; they may be able to see attractive returns but they cannot all get hold of them. As more money flows into an investment category, prices rise and the scope for excess returns diminishes. This already seems to have happened with hedge funds and commodities, and it may be about to happen with private equity, given the amount of capital that it has recently raised.

The most exotic forms of beta are not in these types of asset classes. The frontier for exotic beta is in even more obscure (and illiquid) assets. In an earlier (and still popular) post we discussed the rise of fine art investment funds. In a piece by Jeff D. Opdyke in the Wall Street Journal we are now seeing the formation of wine investment funds.

Amid booming interest in alternative investments ranging from art to collectible coins, wine-focused investment products are starting to appear. Their goal: cash in on soaring interest among consumers and collectors, not to mention prices that are barreling ahead for fancy vintages.

These two types of funds are interesting in that the underlying assets can be enjoyed in some form or fashion. Whether it is hanging a piece of art on a wall or opening a fine bottle of Bordeaux one can seen some underlying value in the assets. However, these markets are illiquid (no pun intended), opaque, at risk to forgery and prone to rapid shifts in taste and fashion. These markets will never be a place where much capital can be put to work, but they do represent the larger trend of investors seeking out the most exotic forms of beta.

The frenetic hunt for alpha (and exotic beta) is unending. Wall Street will continue to commoditize forms of beta that can be done so profitably. Continue to watch the wires for ever more exotic ETFs. A prudent approach to portfolio diversification involves adding non-correlated assets in a measured and cost-conscious manner. The vast majority of investors will never have the opportunity to invest in the most exotic forms of beta, like fine art or wine. But investors can take heart in the fact that over time opportunities for greater diversification will continue to bubble up to the surface.

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